Speculative Market Myopia

The stock market, in the early 1980s, experienced a speculative bubble in hard disk drive manufacturers. All the ingredients existed for the new industry to succeed and for investors to lose money.

The computer industry has a long history with new technology that increased performance coupled with gradually declining costs. Hard drive technology was no different.

From the start, hard drives were complex and expensive, so they were mostly used on mainframe computers. But that changed in the early ’80s. Technology improvements throughout the late 1970s lowered costs and better computer performance drove a need for more storage. Hard drives were in demand.

Industry analysts, in 1979, projected OEM sales at $700 million by 1983, up from $27 million in 1978. The next year, they raised the ’83 forecast to $1.1 billion. Actual sales didn’t disappoint.

The projections set the industry into overdrive. And the industry had all the necessary ingredients for success: high growth projections, rising valuations, easy access to capital, new technology innovation, cost reductions, and new uses for drives.

Seth Klarman highlights the episode in his book as an example of speculative mania:

Speculative activity can erupt on Wall Street at any time and is not usually recognized as such until considerable time has passed and much money has been lost. In the middle of 1983, to cite one example, the capital markets assigned a combined market value of over $5 billion to twelve publicly traded, venture capital-backed Winchester disk-drive manufacturers. Between 1977 and 1984 forty-three different manufacturers of Winchester disk drives received venture capital financing. A Harvard Business School study entitled “Capital Market Myopia” calculated that industry fundamentals (as of mid-1983) could not then nor in the foreseeable future have justified the total market capitalization of these companies. The study determined that a few firms might ultimately succeed and dominate the industry, while many of the others would struggle or fail. The high potential returns from the winners, if any emerged, would not offset the losses from the others.

While investors at the time may not have realized it, the shares of these disk-drive companies were essentially “trading sardines.” This speculative bubble burst soon thereafter, with the total market capitalization of these companies declining from $5.4 billion in mid-1983 to $1.5 billion at year-end 1984.

The industry grew but it led to excessive investment in the space and overvaluation. The twelve public companies traded at an average P/E of 54 — based on the $5.4 billion market value on total earnings of roughly $100 million (of which, $25 million was due to interest income).

The same ingredients that led to the industry’s success turned out to be the investor’s downfall. Picking the winners in any new growth industry is difficult. At its peak, the hard drive industry had over 70 competitors in the space. Picking the winners out of that was impossible.

The case study Klarman cites goes into detail on why investors failed to see what was happening. When the authors of the study analyzed the industry, they generously valued the entire industry at roughly $5 billion in 1983 (based on industry forecasts made in 1983). The disconnect was obvious. In the end, valuations matter.

Yet, enough information was available for investors to piece it together but they were too short-sighted:

…a phenomenon we call capital market myopia, a situation in which participants in the capital markets ignore the logical implications of their individual investment decisions. Viewed in isolation, each decision seems to make sense. When taken together, however, they are a prescription for disaster.

Capital market myopia leads to overfunding of industries and unsustainable levels of valuation in the stock market. While we will use the Winchester disk drive industry to elucidate the phenomenon, capital market myopia has arisen in many other industries at many points in the past. No doubt, it will occur in the future.

The authors cover five lessons from the speculation in hard drive manufacturers that could be helpful in other new industries that emerge.

A broad industry view is key: an investor can get caught up in a company’s future growth projections without checking if the numbers even make sense. So the analysis must start at the industry level first. What’s the market size, market maturity, potential profitability? Those numbers (projected out and discounted to the present) will offer a valuation range for the entire industry. If the total current valuation of every company in the industry far exceeds the top end of that range, then the current valuations are unsustainable. Trying to pick winners out of an overvalued market, that an investor can make money on, is doomed from the start.

Growth is not the same as profitability: the high level of growth attracted so much capital that unprofitability was a likely outcome. The excessive competition led each new competitor to offer a new feature or rely on new technology to set itself apart from the pack. Which forced the rest of the industry to follow suit. New features and new technology are costly. It’s a higher cost to produce the product but also higher R&D spend in order to keep up with competition and costly manufacturing issues tied to using new technology.

A positive return is not the same as a good business: a few investors always make money in a new industry, but that doesn’t mean everyone can. It doesn’t even mean the business they made money on will succeed long term. It only means that a few people got in early and got out before losses kicked in. As the authors state: “Short-term successes of some gave the illusion of long-term profitability for all. Investors should not be fooled by such inevitably ephemeral successes.”

Market instability can be all bad news: rapidly changing technology combined with the lack of industry standards created uncertainty and risk for every company. One misstep by management, like putting too much faith in a feature that wouldn’t sell or technology that wouldn’t work, could differentiate themselves out of existence. On top of that, their customers — the OEMs — were just as uncertain. There was no guarantee their customer would be a repeat buyer or even survive.

Recognize the chains in the process of success: each chain is a series of bets that need to go right for a company to succeed. For example, the technology chain contains decisions on the components to use in each drive, the drive design, and the end-user design. But the bets are also tied to the financial stability of each supplier in the technology chain and its ability to access capital. Any weakness in the chain increases the probability of a setback or failure. For hard drive manufacturers, success was dependent on a perfect series of bets.